Fund Finance 2021: drastic change or steady evolution?

The year 2021 holds exciting opportunities for alternative investment funds as the global economy recovers from the coronavirus crisis, a shock to the financial system that could lead to major changes in investment strategies.

But will it be a year of drastic change or steady evolution for fund financing? And how does the landscape differ from the aftermath of the last financial crisis? What are the outlooks for pricing levels, the availability of financing, the rise of niche lending products and the growing emphasis on sustainable lending?

Spencer Goss, a senior director in institutional banking at RBS International, has dealt with the banking needs of funds for 15 years, taking in the global financial crisis (GFC) and the subsequent surge of the funds sector. He discussed the year ahead with Jeremy Cross, a partner and loan finance lawyer at Cadwalader, Wickersham & Taft.

How is 2021 shaping up in terms of both the volume and the pricing of lending to funds?

Spencer Goss: “The year has started off busily for us; the funds space in general looks really active with a lot of borrower demand and seemingly deep pools of liquidity, with many more lenders than you saw 15 years ago. All of that liquidity is positive because there’s so much demand from borrowers that we need all of those lenders to be participating.

“Last year’s price rises did not particularly reflect any changes in risk or risk appetite; it was more about how banks were allocating their capital across their book as a whole. If you were a large bank with exposure to the corporate market, you needed to direct more of your resources to support the stresses in the corporate world. This meant there was a smaller pot to support fund finance, which spiked the price. Now that things have levelled out, the price still seems to be holding because there is a steady flow of borrower demand and I think margins are going to stay pretty flat, near to where they are.”
 

Has the coronavirus pandemic acted as a dampener on fund activity, or will it create new opportunities?

Jeremy Cross: “There was an initial panic about Covid-19 early last year but later in the year the appetite for funding returned more to normal and investment activity has been very high. I think Covid is now seen more than creating opportunities than as a threat, and banks are getting lots of requests for all types of financing at the fund level.

“There is more appetite for different products like asset financing and preferred equity to allow funds to take advantage of bargains which are now arising because of Covid.

“Subscription financing, which is the traditional product, will still be the major option, but I do see more of the other types of product coming in, especially from alternative lenders. There’s a huge amount of discussion in the industry on this, although my sense is that the chat may currently be a little more than what actually gets delivered for these new types of financing. I think you’ll see different and increased use of these other types of facilities but subscription finance will almost certainly remain the main product.”
 

“An important fact is that fund finance has survived without significant defaults through the GFC and so far through Covid. That means lenders have a significant level of confidence in the product”

Jeremy Cross, partner, Cadwalader, Wickersham & Taft
 

SG: “Yes, I think we’re all expecting that those funds with capital to invest will be really well placed to take advantage of any pricing dislocation in the market and be able to acquire assets. Because there’s more acceptance of subscription finance or fund financing tools, lenders can expect to see their facilities drawn to support that investment activity.

“For asset-backed lending, with any ‘defensive’ needs largely being met last year, we expect demand to be more liquidity driven on the realisation side. Funds that bought assets a few years ago are probably going to have to sit on those assets for another couple of years, but would quite like to return some capital to investors, so they are likely to call on lenders for net asset value-based financing, as a way of getting cash back to investors in advance of being able to realise that value.

“Across the market, lenders have become more accepting of asset-backed financing and I’m sure there will be more NAV-based facilities this year than perhaps in any prior year, but that’s a gradual evolution rather than a drastic change. I don’t see a big change in RBS International’s traditional split of about 85% subscription financing and 15% NAV, for example.

“Historically, there has not been a very deep asset-backed lender market, but I think that is deepening so I’m sure there will be more deals done.”

JC: “An important fact is that fund finance, particularly subscription finance, has survived without significant defaults through the GFC and so far through Covid. That means lenders have a significant level of confidence in the product, as it’s been shown to be robust, so lenders are now looking to lend. After the outbreak of Covid, there was probably a month or two when everybody was worried, but then there was a quick shift of focus to the opportunities available, which was not the case when the financial crisis hit.”
 

How does the pandemic’s impact on the funds sector compare with the global financial crisis of 2007 – 2008?

SG: “The key difference is that the GFC was a banking crisis and this is not. Banks had their own challenges in the GFC so we had to scale down our book, exit some clients and be defensive. This time around there’s opportunity, and banks are in a much better place capital-wise so they can support the funds.”

JC: “In terms of legal documentation and the terms of funding agreements, I can’t tell you one thing that has really come in as a result of Covid. Occasionally there is a debate about whether we should put in a material adverse change clause to deal specifically with Covid, but that is pretty rare in my experience.”
 

Does the rise of green and sustainable lending mean real change for fund financing or is it largely hype?

JC: “A potentially significant change coming down the track is in the whole area of ESG (environmental, social and governance), which is becoming much more of a factor in initial thinking about fund financing. I don’t see it becoming part of all facilities in 2021 quite yet but there are regulations coming on-stream very rapidly that will mean it becomes much more part of the thinking. In many cases that already means putting something into the documentation to affect the pricing, right now most commonly in the form of relatively small moves in the margin, depending on compliance with key performance indicators.”

SG: “I think before long we’ll be having that ESG conversation around every type of fund financing and trying to find ways of influencing the fund to change the behaviour of the underlying portfolio companies. General Partners already have investors encouraging them to do things in a more mindful way; if we start doing that from a lender perspective as well, you can see the two ends working to make a real change, so we will definitely be having that conversation more. RBS International, and the rest of the NatWest Group, is a purpose-led organisation so everything we do, we’re trying to do in a very mindful way, considering the impact it has on the environment and on society. So I think we need to be initiating that dialogue with customers and we need to be challenging them.”